Pay out trust income? Crazy like a fox

The conventional wisdom is that you should transfer money into a trust to avoid future tax on earnings in your high tax bracket.

Strategy: Crazy, but you might arrange to take money out of a trust. In other words, the trust might make discretionary distributions to beneficiaries. It has to do with the narrow tax brackets for trusts and the new 3.8% Medicare surtax on net investment income.

Here’s the whole story: Like individuals, trusts are taxed on earnings, but they cross into the highest tax bracket a lot faster. For 2014, trusts must pay the maximum 39.6% rate on earnings above $12,150, while individuals can earn up to $406,750 before the top rate kicks in.

Also, many trusts face a bigger tax bite due to the 3.8% Medicare surtax on investment earnings. If the surtax applies, a trust may have to pay a combined top tax rate of 43.4% on the federal level. Thus, the trustee might lower the tax liability by increasing distributions to beneficiaries who are in a lower tax bracket than the trust.

Example: You’ve set up a trust to benefit an adult child. If the trust has $30,000 in taxable income and your child, a single filer, has $100,000 in taxable income, the total tax liability in 2014 is $32,069 if the trust makes no distribution to the beneficiary ($10,209 in trust income tax, plus $678 in trust surtax, plus $21,176 in individual income tax).

However, if the trust pays out $20,000 to the beneficiary, reducing its taxable earnings to $10,000, the trust’s tax income bill would come to $2,431 with no surtax due. The child would have an extra $20,000 of income, would have to pay $26,776 in income tax, but would not owe the surtax.

Thus, the total tax would be $29,207 ($2,431 + $26,776) for a savings of $2,862 ($32,069 – $29,207).

Nevertheless, distributing funds from a trust could have consequences that outweigh potential tax savings. For instance, paying out more to a beneficiary should take into account other current beneficiaries while balancing their needs with future heirs (e.g., your grandchildren).

Increasing payments to a younger child could create new tax filing obligations and raise issues about how he or she will handle the money.

Tip: Run the numbers to see if this unorthodox strategy makes sense for your situation.

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